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In its recent decision in Till v. SCS Credit Corp., 124 S. Ct. 1951 (2004), the U.S. Supreme Court has waded into murky waters over the meaning of the Bankruptcy Code’s “cram-down” provisions. The court emerged with a 4-1-4 plurality decision that has far-reaching economic consequences for subprime lenders and secured creditors. The issue addressed in Till is commonly found in bankruptcies: When the debtor seeks to cram down a plan over a secured creditor’s objection, what interest rate must the debtor pay to the secured creditor in order to have provided that creditor with the “net present value” of its claim? The Supreme Court — or at least the plurality opinion — adopted the so-called formula approach to the question of the applicable cram-down interest rate and allowed a borrower to write down a subprime loan to the prime rate, plus a small risk premium of 1.5 percent. The Till decision creates a mechanism for Chapter 13 debtors to cram down subprime lenders and reduce interest rates that likely exceed 20 percent per year to something approaching that of a quality credit — the prime rate plus a small risk premium. Aside from its effect on individual creditors, the decision may affect the securitization market for portfolios of subprime loans secured by assets other than the principal residences of the individual borrowers since those loans are now subject to significant readjustment in the bankruptcy process. Moreover, Till will also apply to business bankruptcies and will provide additional fodder for business debtors to squeeze secured lenders in contested bankruptcy confirmations. As with many bankruptcy cases decided by the Supreme Court, the matter involved a relatively minor amount — a secured loan on a 1991 Chevrolet S-10 truck purchased for $6,395 plus $330.75 in fees and taxes. As originally financed, the interest rate amounted to 21 percent per year for 136 weeks. The debtors defaulted and subsequently filed a Chapter 13 bankruptcy case. At the time of the filing, the secured claim was for $4,894.89 but the parties agreed that the truck securing the claim was worth only $4,000. Under � 506(a) of the Bankruptcy Code, the claim was bifurcated, with the allowed secured claim set at $4,000 and the allowed unsecured claim (the balance) at $894.89. With respect to the secured portion of the claim, the proposed Chapter 13 plan provided that the debtors would keep the truck. Rather than pay the secured claim in full immediately, the debtors would provide the lender with the net present value of the claim by paying over time with interest. Rather than the original 21 percent rate, however, the interest paid on that secured portion of the claim was proposed to be 9.5 percent per year, which was arrived at by augmenting the national prime rate of approximately 8 percent with a risk factor of approximately 1.5 percent. The hearing testimony relating to the creditor’s objection to confirmation of the plan was not particularly informative. The debtors’ expert admitted that he had only limited familiarity with the subprime auto lending market, but offered the opinion that 9.5 percent was “very reasonable” given the fact that Chapter 13 clients “are supposed to be financially feasible.” The bankruptcy court overruled the creditor’s objection and confirmed the proposed plan. The district court reversed, finding that the cram-down interest rate should be set at the level the creditor could have obtained if it had foreclosed the loan, sold the collateral and reinvested the proceeds on loans of equivalent duration and risk (known as the “coerced loan” approach, as discussed below). Citing the unrebutted testimony of the creditor about the interest rate for subprime auto loans, the district court concluded that 21 percent was the appropriate rate. On appeal, the Seventh Circuit U.S. Court of Appeals endorsed a slightly modified version of this coerced or forced-loan approach and found that the contract rate should serve as the presumptive cram-down rate. The appeals court found, however, that the debtors and their creditor should have the opportunity to rebut the presumptive contract rate. By a 5-4 vote, the Supreme Court reversed and remanded the case. The term “cram down” is a bankruptcy term of art reflecting the confirmation of a plan over the objection of a creditor or class of creditors. In this context, with respect to secured claims, the debtor’s plan must provide that the creditor retain its lien on the property and receive distributions (often deferred cash payments) whose total value “as of the effective date of the plan … is not less than the allowed amount of such claim.” Bankruptcy Code � 1325(a)(5)(B)(i) and (ii). The cram-down provision with respect to secured claims in a Chapter 11 case is substantially similar. The plurality opinion in Till took the view that Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of the cram-down provisions of the Bankruptcy Code. The Supreme Court acknowledged the varying approaches of the lower courts in parsing the statutory requirement that a secured creditor receive property with a “total value, as of the effective date of the plan,” that equals or exceeds the creditor’s allowed secured claim. These approaches include the coerced-loan, presumptive-contract-rate and cost-of-funds approaches. Rejecting each of those three approaches, Justice John Paul Stevens, writing for the plurality, instead adopted the so-called formula approach, reasoning that it “reflects the financial market’s estimate of the amount a commercial bank should charge a creditworthy borrower to compensate for the opportunity cost of the loan, the risk of inflation and the relatively slight risk of default.” The formula approach, wrote Stevens, begins by looking to the national prime rate and adds to that a “risk factor” for a “prime-plus” rate. Stevens acknowledged that this approach should comprehend the fact that bankruptcy debtors typically pose a greater risk of nonpayment. Yet the plurality placed the evidentiary burden squarely on the creditors to demonstrate the proper risk adjustment. Stevens’ opinion focused on the debtor’s circumstances rather than the circumstances of the creditor and noted that each of the rejected approaches was “complicated, impose[d] significant evidentiary costs and aim[ed] to make each individual creditor whole rather than to ensure the debtor’s payments have the required present value.” The formula approach focuses on the objective criteria of the prime rate and the characteristics of the bankruptcy estate and the loan (as restructured), and does not focus on the creditor’s circumstances or its prior interactions with the debtor. However, the prime rate represents a short-term borrowing (often on a floating-rate basis), as opposed to a Treasury bill rate, which may reflect inflation expectations and other economic expectations with respect to long-term indebtedness on a fixed-rate basis. A number of lower courts have used treasury bills and other “riskless rate” debt securities of equivalent maturity to reflect these kinds of economic factors. In addition, Stevens’ opinion did not decide the “proper scale” for the risk adjustment although it did cite to cases approving a risk adjustment of 1 percent to 3 percent. Chapter 11 litigants should be aware of relevant lower court decisions, particularly those that use the so-called band-of-investment analysis in which the formula approach was utilized to the various tranches of indebtedness proposed by the debtor. (See In re Deluca, 1996 WL 910908 (Bankr. E.D. Va. 1996), and In re Birdneck Apartment Assocs. II LP, 156 B.R. 499 (Bankr. Under the band-of-investment approach, different risk factors may be assigned to different portions of the indebtedness. Lower court cases adopting the coerced-loan approach or the cost of funds to the creditor will likely have little, if any, persuasive authority in a post- Till litigation environment. Finally, Stevens’ opinion does note the tension between the present value calculation and feasibility, and adds that “[t]ogether with the cram down provision, this requirement [of feasibility] obligates the court to select a rate high enough to compensate the creditor for its risk but not so high as to doom the plan. If the court determines that the likelihood of default is so high as to necessitate an eye popping interest rate . . . the plan should not be confirmed.” It is not clear how the lower courts will apply this particular bit of guidance, as a number of lower-court decisions in the context of relief from the automatic stay have relied upon the inability of the debtor to fund a plan at an appropriate interest rate as “cause” to terminate the automatic stay to allow the lender to foreclose. Thus, the plurality’s comment may undercut well-established authority on the proper approach in connection with motions for relief from the automatic stay. Justice Clarence Thomas concurred in the judgment to reverse the Seventh Circuit’s decision — with an approach that should send a chill down the spine of every secured creditor. Thomas distinguished between the value of the promise to pay over time and the property to be distributed under the plan over time. As a matter of statutory construction, Thomas found that the plain language of the statute does not take into account the risk of nonpayment. Accordingly, the analysis would be limited to an objective analysis of the discount rate without regard to any risk of nonpayment. This approach, to the certain consternation of secured creditors, turns the typical underwriting analysis on any secured loan on its head to only reflect macroeconomic factors — such as inflation and the money supply — and rewrites a contract to reflect those broad macroeconomic trends. This stands in contrast to the specific underwriting circumstances of the loan, the collateral and the debtor — a problem also created by the approach taken in Stevens’ opinion, although somewhat mitigated by allowing a creditor to demonstrate some risk analysis. The court’s dissenters in Till advocated the presumptive-contract rate approach as reflecting the risk of default as well as the cost of collection upon default. The dissent criticized the plurality opinion for undercompensating the creditor and criticized Thomas’ approach for ignoring the context of plan confirmation and the balance of the statute. In this respect, the dissent recognized the broad economic effects of the plurality decision. “There are very good reasons for Congress to prescribe full risk compensation for creditors. Every action in the free market has a reaction somewhere. If subprime lenders are systemically undercompensated in bankruptcy, they will charge higher rates or, if they already charge the legal maximum under state law, lend to fewer of the riskiest borrowers,” wrote the dissenting justices. Without question, the Till ruling will have an impact on the subprime market. There is almost a perverse incentive for Chapter 13 debtors to rewrite the terms of the loan to obtain a substantially reduced interest rate. The “risk premium” will likely develop in each district almost as a matter of course that will be difficult for the creditor to disprove — remembering that Stevens’ approach required the creditor to challenge and to demonstrate that the risk premium was even necessary. Indeed, in one case, the U.S. District Court for the District of Kansas has already reversed the confirmation of a Chapter 13 plan that had used a formula of the treasury bill rate plus a 3 percent risk adjustment — finding that the bankruptcy court was required to conduct a case-by-case evidentiary hearing to determine the proper risk adjustment. In re Smith, 310 B.R. 631 (D. Kan. 2004). Not only will transaction costs increase, but yields on such loans will likewise decrease. This may have a secondary effect on the securitization market, as investors will require more of a cushion to address bankruptcy issues, with a consequent reduction in liquidity and yield in these markets. The plurality opinion in Till recognized that the same approach would apply under any of the applicable deferred payment provisions of the Bankruptcy Code (which would include Chapter 12 for family farmers and Chapter 11 for business debtors). Secured creditors in the Chapter 11 context will also be put to the Till test. The litigation of Chapter 11 cram-down confirmations has typically focused on similar evidentiary issues, with larger dollars at stake. In many courts, the formula approach was utilized to a greater or lesser extent, and the litigants typically used a riskless rate (a T-bill rate of equivalent maturity) and then added risk factors such as quality of the underlying asset as collateral for the now-restructured loan, amortization, market issues and related matters. Till provides greater leverage for the debtor by now allowing it to argue that the burden is on the creditor, not the debtor, to demonstrate the so-called risk premium. Moreover, a creditor very often argues in a motion for relief from the automatic stay that the debtor cannot service the allowed secured claim at a reasonable or market rate of interest and, as a result, cause exists to terminate the automatic stay to allow the creditor to foreclose on the property. In noting the tension between feasibility and the risk premium, Stevens’ opinion may undercut the secured creditor’s position with regard to whether the property is necessary for an effective reorganization — that is, whether an effective reorganization can in fact be accomplished by the debtor, with the debtor arguing that the court should reduce the risk premium in order to enhance feasibility. In addition, it should be expected that certain debtors will advocate the appropriateness of Thomas’ “plain language” approach in arguing that no risk premium is necessary. Ultimately, the Till decision leaves significant uncertainty in the area of valuation of deferred payment streams. As a result, in addition to the likely contraction of credit for the riskiest borrowers as noted by the dissent, the liquidity for subprime lenders may be adversely affected and commercial real estate loan yields may suffer by virtue of the Supreme Court’s ruling. Dennis J. Connolly, a partner in the Atlanta office of Alston & Bird, specializes in commercial bankruptcy and litigation matters.

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